Q and A on the Icelandic Economy

Olafur is the author of the forthcoming: Bad Economics from Iceland (Searching Finance 2012)

Q&A on Iceland

The Spanish radio station Colectivo Burbuja interviewed me on Iceland and the ongoing development of the economy amongst other things. The posted interview is here but the original text in English is below.

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- What were the main reasons of the 2008 Icelandic crisis?

Debt! Private debt in particular! We went completely ahead of ourselves and borrowed massive amount of money. Most of the money went into consumption and buying up existing assets. We had massive housing and stock bubbles at the same time which came down crashing at the same time as well.

It is important to realise that the money we borrowed did not only come from abroad but was simply created out of thin air by the domestic banking system. This newly created money was then spent on stocks, houses, imports and extravagancies; we surely and literally lived on credit. And this credit was mostly created out of nothing by the domestic banking system. But when the creation of new debt slowed down and repayments of outstanding debts failed, the whole house of credit tumbled down and crashed.

-Which were the policies and the strategy of the government to try to dig out Iceland from the hole?

The government and other public bodies tried everything they could to keep the banks alive. A year or so before the crash the Central Bank expanded the allegeable base for repurchasing agreements, basically allowing the banks to come to the central bank and borrow money from it for whatever collateral they could find or create themselves!

The rules became so loose that Bank A could issue a bond, sell it to Bank B which took it to the Central Bank and used it as collateral for borrowed money from there. Bank B would then do whatever it wanted to with the money, e.g. lend it to Bank A if Bank A needed more cash. Bank A could also do the same thing for Bank B. This policy effectively made possible for any bank, as long as it had an accomplice, to borrow money from the Central Bank with a bond issued by itself! Those bonds were later, due to how fragile they were as collateral for loans at the Central Bank, called “love letters”.

When the perfect storm arrived in September and October 2008 the Government, and not only the Central Bank, tried everything it could to catch the falling banks. The major issue was to find foreign cash as the banks needed first and foremost euros and dollars to keep their businesses going. The government and the Central Bank went all over the world, including to Russia, to try to find bailout money for the banks. But the sheer size of the banking system made it impossible as they dwarfed the economy as a whole: at its top, the assets of the Icelandic banking system amounted to roughly 10 times the annual GDP. The British banking system is roughly 4.5 times the GDP of the United Kingdom in comparison.

In the end, the banking system collapsed because its relative size to the economy made it impossible to rescue. Iceland did not “allow” the banks to go bankrupt; we tried everything we could to save them but we could not.

-Should the Icelandic way to deal with the crisis become a model for the rest of countries with problems (Spain,Portugal...) ?

That depends on the structure of the payment system! One admittedly great feat accomplished in October 2008 was to keep the domestic payment system going although 90% of the banking system collapsed in matter of days. On this front, the Central Bank did well and fantastically!

The payment system in Iceland is rather special: everything goes through the same clearing bank, i.e. the Central Bank. In Britain for example, the clearing banks are independent banks, such as Barclays and HBOS.

This means that if Barclays or HBOS go bankrupt, a large part of the payment system in Britain becomes dysfunctional and shuts down! That would be the spark of the utmost chaos as people were not able to use their debit cards or transfer money to and from bank accounts. Commerce would collapse and with it the economy.

In Iceland however, everything goes through the Central Bank: a special entity which is a part of the Central Bank (called “Reiknistofa Bankanna” or literally “The Banks’ Calculation Office”) handles all the electronic payments such as online and debit and credit card transfers.

This structure of the payment system was a very important part of why we managed to keep the system going although 90% of the banking system collapsed in an instant. I do not know the organisation of the payment systems in e.g. Spain or Portugal but if the big banks such as Santander or Banco Espírito Santo are acting as clearing banks in the banking system, “The Icelandic Way” of “allowing” the banks to go bankrupt would be difficult to carry out.

So it depends to a large extent on the structure of the payment system whether banks can be allowed to go bust or not. In case of Spain and Portugal, I cannot say.

-Jón Asgeir Johannesson and Björgólfur Guðmundsson have been usually blamed as some of the main people who helped to cause the crisis, are they still influential in the economy and the politics?

Yes and no. Johannesson allegedly still controls the biggest media corporation (his wife, Ingibjorg Palmadottir, is registered for 90% of its stock). Johannesson himself is not so prominent any more however. He probably does not want to, especially as he is being sued by the bankrupt estate of Glitnir Bank which he was a stakeholder in. The bankrupt estate is accusing him of practically using the bank to extend massive amount of credit to himself without any credible business plan behind the act. He himself personally owed the Icelandic banks 126 billion krona at the time of their collapse (remember this figure when the so-called debt forgiveness is discussed below) according to the research report of the Parliament.

Gudmundsson was one of the few major players that were actually declared bankrupt as many of them dodged legal action by holding their debts and assets in separate asset holding companies, thereby freeing themselves personally of any bankruptcy claims. Gudmundsson has all but disappeared from the scene although his son, Bjorgolfur Thor, is still in the news every now and then.

- Did somebody ring the alarms about the dangerous position Icelandic banks were in during the boom years before the financial system implosion? If so, why those voices were not heard?

Yes, multiple persons, banks and rating agencies did. In fact, the “mini crisis” of 2006 was sparked by sober foreign analysts, such as those of Danske Bank, pointing out that the expansion of debt that was taking place in Iceland had to stop one day. In Iceland, one of the most memorable persons who questioned the boom was an unknown doctor of psychiatry, Dr. Andres Magnusson. His analysis was basic, economics based and built on national account figures that everybody could find online.

Those voices were heard but ridiculed, both by politicians and the banks. The then Minister of Education, Thorgerdur Katrin Gunnarsdottir, famously said that one of the foreign analysts, Richard Thomas at Merril Lynch, “was in need of re-education” after having expressed his pessimistic view of the then Icelandic miracle. And as an example of how closely knit together business and politics in Iceland are, it should be mentioned that Gunnarsdottir’s husband, ex-handball star Kristjan Arason, was the CEO of Retail Banking at Kaupthing Bank. They dodged bankruptcy by moving their liabilities into an asset holding company called “7 Right” in February 2008, eight months before Kaupthing Bank went bankrupt.

A massive PR campaign was started after the mini crisis in 2006 to strengthen the idea of the entrepreneurial Vikings from Iceland. Even the president – now just newly elected for his fifth consecutive 4-year term – participated in the PR. Many have and never will forgive him for being that cheerleader.

The reasons why people were so blind and unwilling to accept the fragility of the economic boom are one of the enigmas behind all booms-and-busts. “This Time Is Different” and “We Are Special Because of...” were phrases that everybody heard repeatedly, just as in any other credit fuelled boom in the past in other economies. The self deception was almost flawless. It did not help that the media in Iceland was, and is, owned by the business moguls themselves.

-Most journalists (for example Roger Bowles) point at the Icelandic Central Bank as one of the main causes of the crisis, What was the Seðlabanki role lead by Davíð Oddsson during the pre-crisis years? What could it have been done better to avoid the crash?

Personally, I don’t think it mattered much that Oddsson – a lawyer and an ex-prime minister who pretty much had his successor appoint him as the governor of the Central Bank – was in charge at the Central Bank. Oddsson had an army of economists under his control that should have known what was going on but they were all blind to the impacts of the debt build-up.

The Central Bank’s role was typical: to control inflation (the inflation target in Iceland is 2.5%) and to maintain financial stability. On both of these fronts, the Bank failed miserably. Since the 2.5% inflation target was adopted in March 2001 until October 2008 there were in total 17 months (out of 92) where the target was reached. Regarding maintaining financial stability, well, I don’t think I need to stress its failures there.

The Central Bank should have stopped the debt build-up as it was the private debts that brought the economy down. But the economists at the Central Bank, as in other central banks in the world, did not realise this problem since they were all educated in neoclassical economics where private debt does not matter and banks are simply just “intermediaries” between savers and borrowers and not producers of purchasing power as they are in reality. Iceland is the typical example of an economy that was ruined by bad economics.

-You have been very critical in your articles about the future of the Icelandic pension system, why?

Ah, yes! The pension system! Our glorious pension system!

The pension system of Iceland is one of the biggest ones in the world when compared to the domestic economy. Its assets amount to around 135% of GDP. Only Holland and Switzerland are in the same league.

The problem, however, is twofold. First, even though the gross assets of the pension system amount to this gargantuan figure, there is a hole in its balance sheet amounting to 40% of GDP. This means that the pension funds have promised to pay out money to future pensioners that they do not have and will not ever have.

This problem is well-known and widespread in Europe and North America. But it is the other part of the pension system problem that worries me. A lot!

The pension funds have to get around 3.5% real return on their assets if they are going to fulfil the promises they are legally obliged to. This means that pension funds will not lend out money or buy stocks or do whatever they are doing unless they are promised a return equal to 3.5% plus the rate of inflation. That means e.g. almost 9% in nominal terms now that inflation in Iceland is 5.4%.

As a consequence of the size of the funds, they hold more than half of the financial instruments registered in the Icelandic Financial Exchange. The problem that now arises is that because the pension funds are so big and are legally required to get this high rate of interest, they effectively push the rate of interest in the economy upwards!

One of the foremost reasons for high rate of interest in Iceland is the organisation of the pension system. In other words, the government cannot sell its bonds on the market unless it promises the buyers, which are to a large extent the pension funds, very high rate of interest. As a case in point, the interest rates on 10 year government bonds are 7.2% at the moment. And as high rate of interest bring high rate of financial instability, the pension system of Iceland is a real problem.

-Is Iceland still fighting a housing bubble? How many years of net income does a family need to buy an average size house/flat?

This is a tough one for when does the “bubble” definition start to apply to a market?

Yes, house prices are going up again mainly because the banks have begun to offer non-indexed loans (normal mortgages in other Western countries) to households to buy flats and houses. This has become very popular: people are borrowing money, again, to buy houses and the banks are creating this money out of thin air as they have always done, especially before the crash in 2008. Consequently, house prices have gone up again after having dropped by 35% in real terms, a very typical figure when house bubbles burst. But the upward movement in real house prices is very limited simply because inflation is still high.

No official figures exist regarding the second half of the question. However, a comparison can be made by using data from Statistics Iceland regarding the cost of housing in different countries. That comparison is shown in the following two graphs:

(Notes: Share of housing cost is calculated as the median of the proportion of housing cost which is calculated after the proportion of housing cost in total disposable household income as been calculated for each individual.

If a household uses 40% or more of its disposable income in its house it is considered to have a housing cost overburden. The second graph shows the proportion of people who have housing cost overburden. See Statistics Iceland for details.)

-The most common Icelandic loans are not variable interest ones but indexed ones, something not common at all in the rest of Europe, could you explain how those indexed loans work?

OK so normal (European) mortgages work in the following way: you borrow 100,000 euros to buy a house. Let’s say that you will repay the loan back in 20 years and every payment is equal to the previous one. Let’s assume a nominal rate of interest equal to 5%. That means that every monthly payment for the next 20 years will be 660 euros. This amount will not change as long as the rate of interest does not change. Some loans are tracker loans, meaning that they e.g. follow the LIBOR rate with some premium. So the final interest rate on those loans will be LIBOR + the premium that the lender sets.

The Icelandic indexed mortgages are considerably different! Let’s assume that you borrow 100,000 krona and you are going to repay it in the same way as the EUR loan above. This is a pathetically low amount as you would need around 30 million krona to buy the median house. But for the sake of argument, let’s just stick to similar figures.

The stated rate of interest on the indexed Icelandic mortgages is not the nominal rate of interest but the real rate of interest! And on top of that real rate of interest – which is most often fixed for the whole loan period – you have to add the current rate of inflation to find out the nominal rate of interest. So if the real rate of interest on an Icelandic mortgage is e.g. 4% (the cheapest loans during the boom had 4.15% real rate of interest) you have to add the rate of inflation on top of that to find the total rate of interest. The inflation in Iceland is now 5.4%. So the total rate of interest on that mortgage is 9.4%.

The peculiarities do not stop there. The inflation part of the total rate of interest is not paid back monthly as in the case of regular European mortgages but is added on top of the principal.

This means that if the rate of inflation over one year is e.g. 5% the original borrowed amount (100,000 krona) grows by 5% before you make a repayment. So imagine you borrow 100,000 krona on 1st of January 2011. On 1st of January 2012 the inflation over the last year is measured to have been 5%. That means you do not owe the bank 100,000 krona on 1st January 2012 but 105,000 krona. But of course, you only got 100,000 krona from the bank.

Let’s assume now that on 1st January 2012 you repay 10,000 krona plus interest. That means that you owe the bank 95,000 krona after the repayment on 1st January 2012. Now the inflation between 1st January 2012 and 1st January 2013 is for example 10%, which historically is not such an unlikely inflation level in Iceland. That means you owe the bank 104,500 on 1st January 2013 (95,000 * 1.1 = 104,500). So you can see that as long as inflation is high, you kind of feel like a hamster in a wheel.

It is important to realise that the amount that is added on the top of the principal does in fact never exist. It is a simple accounting figure that happens only on the bank’s books. The bank will however profit from this accounting figure as it appears on its books as appreciation of the price of its assets and / or as interest rate income. So in Iceland, banks profit if inflation takes place. The higher the rate of inflation, the higher will the profits of the banking system be in Iceland.

Notice also that because it is the principal that grows by the rate of inflation the monthly payments slowly grow as time passes. In the example here above where 100,000 euros were borrowed at 5% nominal rate of interest, the monthly repayments were 660 euros, no matter the rate of inflation. The total amount repaid over the whole 20 years is 158,289 euros.

In Iceland, the first repayment of a 100,000 krona loan at 5% rate of interest would be 660 krona only if the rate of inflation is 0%. But if the annual inflation is e.g. 3% for the whole 20 years, the first monthly payment is not 660 krona but 662 krona because the principal has grown. The last payment, 20 years later, would be 1,192 krona or almost double the first payment. And the total repaid amount is not 158,289 krona as in the case of the normal European mortgage, but 216,241 krona. More than double the original borrowed amount. This is so because the interest rates on the loan are calculated on the original principal (100,000) plus any increments that take place due to inflation.

The argument for this system is to maintain the real purchasing power of the money that the bank lent out in the beginning, i.e. the 100,000 krona. But I have criticised those mortgages extensively and largely blame the way of indexation for why we can never have a stable economy in Iceland. There is not a shred of doubt in my mind that this indexation system destabilises the Icelandic financial system. But, according to neoclassical economics, this should not be a problem since “money is neutral” in neoclassical theory. But this is obviously a huge problem in my opinion! So again, the Icelandic economy is being turned into ruins by bad economics.

-Did the families really get a major debt forgiveness? What is the present level of debt of the families and the total Icelandic economy debt (including government, families and companies) compared to the 2007 level?

The newest figures I have seen regarding the “forgiveness” of household debt are from February 2012. By that time, households’ debt had been written down by 196.3 billion krona (1.24 billion EUR, around 12% of GDP). However, the majority of the write-offs were due to illegal foreign-currency-linked loans that the banks lent out but were later deemed illegal. So they had to write them off. The write-offs due to that factor alone were 146.5 billion.

The rest (49.8 billion ISK) was due to official expedients, such as the allowance to write off one’s mortgage down to 110% of the market value of the property used as collateral. But if your indexed mortgage had not risen above 110% of the market value of your property, you would not get any debt written off.

However, due to the peculiarity of indexing mortgages in Iceland, the 196 billion written off were weighted out with increases in the indexed principals of debt. Therefore, the bottom line is the same: households’ debt is still around 250% of disposable income, even higher than it was in 2007. As a proportion of GDP, households’ debt has decreased slightly from 120% in 2008 to 110% in year-end 2011.

Non-financial companies got a major debt relief however and that was more or less the banks’ own initiative to do so. Non-financial corporate debt as a percentage of GDP has dropped from around 325% in 2008 down to just below 200% in 2011. Most of it was simply written off but Icelandic firms are nevertheless still one of the most indebted ones in Europe.

Government debt skyrocketed during and after the crash, to a large extent to save the equity of the Central Bank which became technically bankrupt because of loses on its “love letters” (see above what the “love letters” were). In 2007, the gross federal debt was 43% of GDP. It was 115% of GDP at the end of 2011.

So the debt figures are roughly the following (in per cent of GDP, year-end 2011): households – 110%, non-financial corporations - 200%, the government – 115%.

-Who is running the Icelandic banks now?

Good question! We don’t know!

When the banks went bankrupt they went into receivership. The new banks that were established on the foundations of the old ones were partly done so with money from the government. The State holds 81% in the New Landsbanki, 13% in Arion (the New Kaupthing Bank) and 5% in Islandsbanki (the New Glitnir). The rest is owned by the old banks or their bankrupt estates to be exact.

The main owners of the new banks are therefore those who own bonds issued by the old banks as they are entitled to payments out of the bankrupt estates. The public has no idea who holds those bonds and have therefore essentially no idea who are the true owners of the Icelandic banks. There have been speculations that the principal owners are some foreign hedge funds or even some of the old Icelandic business moguls. But nobody knows for sure.

-You write frequently in your articles about the capital controls, what are the effects of those controls on the economy?

The major effects are on the exchange rate. The exchange rate of the Icelandic krona is artificially kept higher than it really should be by locking money inside the economy with the capital controls. This is in violation of the European Economic Area contract where the free flow of capital must be allowed as part of the “Four Freedoms”. But Iceland was hit by a systemic collapse so an exception is made for the time being.

-What are the consequences of the Icesave conflict? Is Iceland ready in case they lose the trial?

The consequences of the Icesave (“IceSlave” as it was nicknamed in Iceland) could be severe not only for Iceland but for the whole system of deposit insurance schemes in Europe.

Icesave is essentially an international quarrel between Iceland and the ESA (EFTA Surveillance Authority). The argument is whether or not there is a government guarantee on the bank deposit insurance scheme in an EU & EEA country. Iceland’s case is that there is no such guarantee but ESA disagrees and also withholds that the Icelandic government did not treat all depositors of the Icelandic banks equally when all deposits in Iceland, whether they were in the ownership of foreigners or not, were guaranteed but not deposits outside the Icelandic financial system.

The dispute is now on the desk of the ESA court. If Iceland wins, it could be a clear legal precedent in EU countries: all of a sudden the deposit insurance schemes in EU countries, implicitly considered to be backed up the public finances, could be deemed effectively empty or dysfunctional. Depositors’ trust in their domestic deposit insurance scheme could be severely harmed, even leading to bank runs.

If Iceland loses the possible harm for the public finances could be prominent. However, there is also doubt whether the deposit insurance was to be paid out in the currency that the deposits were in (GBP or EUR) or in the currency of which the deposit insurance was denominated in, i.e. Icelandic krona. If Iceland loses and has to pay out pounds or euros, the country is as good as bankrupt. But if Iceland loses and can pay the insurance out in Icelandic krona, the country should do alright afterwards.

-Do you think the international media fully understands the Icelandic crisis, have they described it in a too romantic way?

Yes, my feeling is that they generally have. The Icesave dispute and how it was romanticised as an uproar of the Icelandic people against the international financial powers – when it was more of an uproar against the Icelandic government who was willing to sign almost any deal whatsoever – is one case in point. The so-called debt forgiveness is another.

The newest one is regarding the fact that GDP in Iceland, measured in Icelandic krona, is growing again (4.2% GDP growth between 1Q11 and 1Q12). Sure, there is economic growth measured in Icelandic krona but the question is whether the devaluation of the krona has to be taken into the account or not. Iceland’s GDP was 20.4 billion USD in 2007 but in 2011, due to the collapse of the currency, 12.7 billion USD. So are we back on track or not?

Yes, we’re growing again but we have a long way ahead of us before we make up lost ground. And my fear is that if we do not fix the dysfunctional banking and pension systems, we will never make up that lost ground. And that has not, perhaps understandably, been picked up by the international press.

-Is Iceland going to adopt a new currency? Which one would suit the best?

I sincerely do not know if we will. The currency question in Iceland is one of the economic and political questions that we have to answer before we can move on with our lives.

One option is to continue with the krona but many dislike that option wholeheartedly since they believe that the krona will do nothing but collapse again and again. So they want a “stronger” currency. The appetite of Icelanders to adopt another currency runs from the fact that the Icelandic krona has not been very stable in the past, to say the least. The krona has in fact lost 99.95% of its value against the Danish krona since it was established on a par against that currency in 1918. Most of the devaluation happened during the 1970s and 80s and not the early 2000s though.

The official direction is to enter the European Union and adopt the euro. That plan is understandably not considered to be very tasty by many people given the economic turmoil in the EU countries.

Another rather prominent idea is to unilaterally adopt a foreign currency. The menu of possible countries runs or has run from the Canadian dollar to the euro to the Norwegian krona back to the US dollar. The Canadian dollar idea is the most prominent one at the moment but historically the support for a foreign currency has almost been an object of fashion. So who knows, maybe in one year’s time we’ll be talking about some other currency and everybody would like to adopt that one.

Which would be the best one? I cannot say. Nobody can. I can however say that the main problem of the Icelandic economy is not its currency but the organisation of the banking and financial system. The economy will never be stable for the longer term if the financial system is not fixed and that has nothing to do with our choice of which currency we choose to use as the legal tender. We have to fix the financial system on our own, changing which currency we use will not do that for us.

-Iceland population is well educated, the demography is healthy, aluminium prices, energy prices and even water prices will go up on the medium term, there's a bright future.. but what are the main threats that will have to face the country?

In the near future, it is the economic crisis in the European Union. We need income from exports and tourism to rebuild the economy and a large part of our trade is done with European countries. So if Europe falters, so will we.

But even if European leaders solve their mess – let’s hope they will – the Icelandic economy is not out of the woods. Yes, the nation is well educated and many Icelanders that go abroad, for e.g. studies or temporary work, want to move back home. We have also plenty of renewable energy, clean water and territorial waters full of fish. So what is there to stop us?

Ourselves! There are powerful pressure groups in the Icelandic economy that want to keep the status quo in the financial system, even though that would be very suboptimal. Those pressure groups run from e.g. the representatives of the banks, pension funds and the old business moguls to and through the politicians. So as long as the old politicians are still in the Parliament, doing deals behind closed doors, I have little hope for true long term recovery. The crash in 2008 taught me to be very suspicious towards politicians, especially if they have been in the Parliament for long. Gunnarsdottir and Arason are just one extreme example of too much and blatant connection between politics and business, especially banking, in Iceland. Gunnarsdottir is still an MP.

More importantly, we need to get our heads straight regarding economics. The policy makers in the financial system are unfortunately following neoclassical economic theory that has no foundations in reality. They are also advising the MPs who naturally think that the neoclassical economists know what they are talking about. But since neoclassical economics is responsible for freak systems, such as the indexation of debt, we need to correct that mistake.

Icelanders need to renew further the political leadership of all political parties. We need to drop people that are doing deals behind closed doors and effectively representing special interest groups. We need new people into the Parliament who are willing to make unpopular but necessary choices such as regarding the pension system. And we need to sway away from economic policies built on the dreamt-up foundations of neoclassical economics.

If we manage to get this done, the future is truly bright for Icelanders. But without those improvements, especially the ones on the financial and pension systems, I am not so optimistic about the nation’s long term prospects. I would at least think twice before moving back home.